Tuesday, September 6, 2011

Moral hazard, systemic risk, and financial markets

It is increasingly evident that the regulators and policymakers have learnt little from the bitter lessons of the sub-prime mortgages meltdown induced global financial market crisis.

As Simon Johnson points out in an excellent post, the numbers of too-big-to-fail banks looks set to grow as more mergers are in the pipeline, despite growing signs of risk build-up. He points to the recent decision of beleaguered Bank of America (BofA) to court and accept $5 bn from America's most credible investor, Warren Buffet, as sure sign of serious troubles at the bank.

The bank is the largest bank-holding company in the United States, with assets at the end of June of more than $2.26 trillion. It services one in five home loans, and with 5,700 branches assembled through decades of mergers, it counts 58 million customers. Investors are worried at BofA's long-term health, despite the roughly $20 billion set aside to atone for its mortgage misdeeds at the height of the housing bubble, in light of the $ 9bn in losses suffered by the bank over the past 18 months.

He also points to an interesting NBER working paper by Bryan T. Kelly, Hanno Lustig and Stijn Van Nieuwerburgh who highlight the distortions in the price of put options for the financial sector stock index relative to put options on individual banks' stocks. Put options, which are effectively an insurance against price collapses, are cheaper if investors percieve less risk of such eventualities. They write,

"Investors in option markets price in a substantial collective government bailout guarantee in the financial sector, which puts a floor on the equity value of the financial sector as a whole, but not on the value of the individual firms. The guarantee makes put options on the financial sector index cheap relative to put options on its member banks... The government’s collective guarantee partially absorbs financial sector-wide tail risk, which lowers index put prices but not individual put prices, and hence can explain the basket-index spread. A structural model with financial disasters quantitatively matches these facts and attributes as much as half of the value of the financial sector to the bailout guarantee during the crisis."

The authors find that index puts were a lot cheaper than the appropriately weighted sum of put options on individual bank stocks, especially during the recent financial crisis. They argue that because "investors price in substantial government bailout guarantees for the financial sector as a whole", they find little need to insure privately against overall collapse. This disproportionately benefits the TBTF institutions (over smaller institutions), since any problems individually affecting each of them will translate into a risk for the financial sector as a whole.

In simple terms, the moral hazard created by the sub-prime bailouts and the the resultant market expectations have had the effect of lowering the price of risk for the TBTF institutions. The cause of this risk reduction being the effective bailout guarantee for TBTF institutions that governments provide. The handful of TBTF institutions are so large that they have become proxies for the financial market itself. As Simon Johnson writes, "No other sector in the United States economy gets anything like this kind of insurance". I would call it subsidy.